Sunday, February 22, 2015

The Fed Funds futures continue to point to the first Fed rate hike in late Q3/early Q4 of 2015.

The debate is now focused on whether this timing is unrealistic. To be sure, whether we have a hike in September of 2015 or in January of 2016 will have little direct impact on near-term growth. But could an earlier hike exacerbate disinfaltionary pressures in the United States and globally?

Some argue that the weakness in inflation has been driven by energy markets and once we have some stability in that sector, price growth will speed up again. However we are also seeing signs of slowing inflation in the "core" measures:

Core CPI:

Core PPI:

Moreover, this slowdown is coming from a variety of sectors - for example healthcare:

Source: Credit Suisse

Therefore even if we see some gradual increases in energy prices (which may take some time), inflation measures may remain significantly below the Fed's target for a while. So what could prompt the Fed to act in the next few months? Some argue it will be wage pressures.

While we've had a number of forward looking indicators pointing to higher wage growth ahead, we haven't seen that trend in the official figures thus far. Americans are certainly working longer hours, but the pay per hour continues to grow at 2% per year. That in no way constitutes wage pressures - at least not yet.

One of the arguments for higher wages going forward is poor productivity growth in the US. Companies will be forced to hire more people and pay them more - the argument goes - in order to compensate for difficulties they are having in achieving growth with their existing workers (via technological and process improvements, etc.). Perhaps.

Source: Evergreen GaveKal

But even if we see a modest improvement in wage growth in the next few months, the FOMC remains concerned about pushing the dollar higher and destabilizing global economic conditions - the equivalent of another "taper tantrum". For example, it's important to keep in mind that the Greece situation is likely to resurface again in 4 months or earlier.

The FOMC: - ... the increase in the foreign exchange value of the dollar was expected to be a persistent source of restraint on U.S. net exports, and a few participants pointed to the risk that the dollar could appreciate further. In addition, the slowdown of growth in China was noted as a factor restraining economic expansion in a number of countries, and several continuing risks to the international economic outlook were cited, including global disinflationary pressure, tensions in the Middle East and Ukraine, and financial uncertainty in Greece.

And for those who still believe that the Fed is too domestically focused, just take a look at what occupies a good chunk of Janet Yellen's time these days.

Source: WSJ

At this point we would need to see a major shift in domestic wages and inflation indicators as well as a more stable international economic picture in order for this dovish FOMC to move on rates. The expected rate hike in the next 6-7 months indeed seems unrealistic.

Let's take a look at the recent developments in the US energy markets and the seemingly contradictory reaction by equity investors.

First of all, while we continue to see significant declines in the US rig count (both oil and gas), ...

Source: Banker Hughes

... American crude oil production remains at record levels and still rising. It's going to take time for this momentum to turn.

Source: EIA

Part of the reason is the increasing productivity of new rigs in the US.

Source: EIA

Moreover, outside the US some major oil producing nations such as Russia and Iraq - desperate for hard currency - will maximize production in the months to come. Global production will therefore continue to rise.

The second key development has been a relatively steep crude oil futures curve (contango).

Source: barchart

This is encouraging crude investors to store oil. The arb involves buying spot crude, simultaneously selling forward, and storing for delivery at a future date (Profit = Forward Price - Spot Price - Storage Cost - Financing Cost). If the arb persists, the trade can be rolled. That's why this past week we saw the largest spike in volume of crude in storage.

Source: Investing.com

Moreover, the absolute levels of crude in storage are now at the highest level in some 80 years.

Source; EIA

As a result, analysts expect Cushing, OK (the WTI crude delivery/storage hub) to run out of storage soon.

Source: @jenrossa

Crude in storage is on the rise outside the US as well. As an example, Iran just launched a huge floating oil storage unit in the Persian Gulf (built by Samsung). This facility stores 2.2 million barrels of crude.

The most important development in 2014 of course was the historic shift in the crude oil production cost curve, capping crude prices at $75-$80/bbl for some years to come.

Business Insider: @themoneygame

Now, with these production fundamentals in place, rapidly growing amounts of crude in storage, and longer-term prices capped way below milti-year averages, why are energy firms' shares still relatively expensive? For example, over the past couple of years spot crude oil is down 45%, while the energy component of the S&P500 is up 2%.

And forward P/E ratios are more than double the historical averages - these are some of the most expensive large cap shares in the market.

Equity markets seem to be betting on a quick decline in production and sufficient recovery in crude prices to return the energy industry to stronger profitability in the nearterm. There is also the view that some energy firms will remain resilient due to their midstream operations - storage, transport, and refining. And we've all heard talk of consolidation and M&A activity in the space which may also support share prices (see story). A number of analysts have turned constructive on the sector.

Source: Goldman Sachs

Furthermore, from the technical perspective many portfolio managers have been heavily underweight the energy sector for months and some believe that the eventual rebalancing will drive up share prices.

These are all solid arguments. However given the current lofty valuations, if we don't see a major improvement in crude prices in the next few months, energy shares may take another leg down. One can see this nervousness in the credit markets as HY energy credits remain near historical wides to the rest of the market (chart below). For those who wish to jump in at these levels, be prepared for significant volatility and deleveraging in the energy sector.

Saturday, February 21, 2015

The purchase programme of the ECB pushes towards the nationalisation of risks in the short-term, and in the long-term reduces the interests of the member States in keeping the Euro alive.

On the 22nd of January this year, the European Central Bank (ECB) launched a Quantitative Easing programme (QE) of more than 1 trillion bonds, which will be shared in a buying programme of 60 billion a month for a duration of 18 months. Ignoring for simplicity’s sake the fact that in the more than one trillion there are also private debt bonds, the QE will have an impact on inflation, but it will be reasonably heterogeneous in the Eurozone; in fact, it can be suspected that it will be more difficult for peripheral banking systems to transmit liquidity into the real economy. Overlooking the possible reactions of the other central banks, it is conceivable that the Euro will reach the value of the dollar, an equality which will, however, massively favour the big exporting economies. In any case, the weakness of the QE is the allocation of risks which could be neglected if the hypothesis of the ‘break-up of the Euro’ was sure to rule out relying on the anti-spread shield. The issue is that to activate the shield – if it were ever necessary – a political convergence on a full sharing of the risks at a European level would be needed, but there are no signs on the horizon.

To understand what the risks are to which we are referring, it is appropriate to take a step backwards to investigate why the purchase of government bonds has not been decided according to the best practice of the central banks of the world, namely without paying interests to the ECB and without discriminatory treatment on the risks of public debts of different member countries. Behind the tensions that led to this decision there is the German-made theory that a different intervention from the ECB would have created an undue mixture between monetary and fiscal policy and encouraged the moral hazard of the periphery. By not paying interest to the ECB, a member country could have, for example, reduced taxes or increased public spending, and thus have used the measure of the European monetary policy to national tax ends. Similarly, imagine the loss in value of the government bonds issued by a member country and bought by the ECB; such a loss concerning a national state would have been reversed on all Eurozone taxpayers. But the moral hazard theory is not supported by the facts.

On the issue of interests, some decisions made by the ECB certainly have fiscal policy implications but the terms are different. In the two-year period 2010-2012, with the Securities Market Programme (SMP), the ECB increased its budget of around €220 billion of bonds issued by Eurozone Peripheral Countries (EZPC). Considering the bonds expired in the last 24 months and the sterilisation performed on the secondary market, in December 2014 around €160 billion of government bonds – based on the decision of June 2014 – were not placed back on the market leading to an increase in the monetary base. What’s unusual about the SMP is that, unlike what happened with the buying programmes of the FED, Governments are required to pay interest to the ECB. In total, a flow of around ten billion Euros a year is estimated, which is then distributed pro rata in the Eurosystem (Germany 18%, France 14%, Italy 12% and so on). In other words, Germany through the Bundesbank receives nearly 4 billion of interests from the EZPC. So thus far, the monetary policy has induced fiscal transfers between member States, but from the periphery to the centre, not vice-versa.

On the issue of credit risk, i.e. the loss in value of a government bond, the solution of the buying programme decided on the 22nd January is that – with the aim of not creating undue mixtures – the ECB will directly purchase government bonds of the Eurozone for around 100 billion (8% of the QE), hence mutualising the associated risks, and it will provide liquidity to the central banks for 1 trillion to allow for the purchase of government bonds (80% of the QE) and of bonds issued by supranational European institutions (12% of the QE), including the ESM, i.e. the former sovereign bailout fund, which will likely have a relevant share.

The purchase of bonds will be based on the share of each Eurosystem country (see above).

At the end of the purchase, the national central banks will have the bonds as assets and in the liabilities a debt owed to the ECB for the same amount. This means that the national central banks are ensuring the ECB from risks of losses in value which could occur on that portion of the public debt of member States that will be interested in the programme. For example, imagine that the Bank of Italy buys 100 billion Euros of Italian government bonds. Then, if in the future Italy were to devalue the debt by 60%, in the assets of the Bank of Italy there would only be 40 billion Euros (or, equivalently, 100 billion Lira) and in the liabilities there would continue to be 100 billion worth of debt owed to the ECB. In practice, the mechanism with which the national central banks will lend the guarantee could also be different from the one suggested previously, but the basic reasoning does not change. In other words, by finishing in the assets of the national central banks, those government bonds become de facto subjected to foreign law, and as such, if the member country were to leave the Euro it could not reduce the value of the bonds by redenominating in the new national currency and then devaluing them, but it would be required to repay their full face value in Euros to the ECB.

From the financial point of view, the scheme adopted for the QE is therefore that of credit derivatives. In more explicit terms, the national central banks are selling a credit default swap to the ECB and they are cashing the premium. Obviously, it could be debated at length how a national central bank can issue guarantees on the public debt of its own state given the “connection” of the risks between the two entities.

Quantitative analysis based on the so-called “Italy risk”, applied to the amount of government bonds that the Bank of Italy should purchase through the programme, allows us to say that Italy should cash, for a similar insurance, more than 1 billion Euros a year until the maturity of the bonds purchased.

By taking on these risks, the national central banks will be remunerated through the interests on the government bonds purchased, therefore according to the same criteria of asymmetric distribution followed for the risks. The interests retained by the national central banks compensate for the guarantees given to the ECB for the risks of national public debt of the Eurozone included in the programme.

As for the purchase of bonds issued by European institutions (12% of the total), including an important role that will be taken on by the ESM, any loss in value will instead be borne by the member States according to their percentage of participation to the Fund (27% Germany, 20% France, 18% Italy and so on), given that the risks related to these bonds have been shared. In reality, at least for the bonds issued by the ESM, if one takes into account that for this Fund the risks have already been shared out by statute, the QE creates a sort of mutualisation to the square. Therefore, it is important to investigate the reasons for a similar decision. A possible explanation comes from the composition of the risks of the ESM that sees a significant amount occupied by the public debt of Greece. Its restructuring would determine losses in excess of the capital base of the ESM; therefore it seems that, in the doubt that in the future a member state may decide not to participate in the recapitalisation of the Fund, the QE will have pre-emptively resolved the problem by securely transferring the risks of such excess losses to the national central banks.

Also in this case the scheme follows the financial point of view of the credit derivatives. What’s the related premium? Well, taking the risk of Greece as a proxy for excess and neglecting the laughable returns of the ESM bonds, in the case of Italy – just to make an example – the premium associated with the purchase of bonds issued by the ESM would be around 1 billion Euros a year. This time however, without substantial compensations to the Bank of Italy for the insurance provided.

The argument can now be completed by referring to the 8% of the purchase of government bonds carried out directly by the ECB and whose risks are therefore shared at a European level. In this case, the credit derivative is sold by the ECB and bought by the member states of the Eurozone. By conducting quantitative analysis similar to those carried out so far we can see, for example, that in the case of the Italy the insurance for the 8% of “shared” risk on the Italian government bonds is worth around 100 million Euros a year.

The decision announced on the 22nd January is therefore not financially fair, nor are there “gifts” to “weak” countries of the periphery, and has little taste of United States of Europe. Rather, it is in line with the previous decisions, including that of mid-January which has set forth the possibility of relieving the Fiscal Compact in the presence of a recession not only in the Eurozone but also in the individual countries. This was also certainly a useful decision, but which does not address why the founding fathers of the Eurozone did not take into consideration the idea that the economic cycles of the member States could be misaligned. It will be random, but at this very moment the European regulators who deal with the risks in the balance sheets are saying that it is time to discriminate the government bonds of the different Eurozone members. For some time a metamorphosis of the European Union to the sum of the member States has been underway, and unfortunately the monetary policy did not intervene as it could have done.

Favorable terms of trade and eager investment in manufacturing and real estate has propelled Chinese growth in recent years. Now, a high debt burden from overinvestment, rising manufacturing costs, and an appreciating currency are signs of stress on this successful growth model.

Source: The Economist

Source: Trading Economics

USD / CNY

Source: Trading Economics

This stress appeared in troublingly low GDP last month due to weakness in both real estate and manufacturing markets.

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics

Aside from a 30% YoY jump in FDI last month, we have seen large capital outflows from China and slowing foreign direct investment over a longer period. Reuters highlights two important considerations for why there be more to January's numbers than meets the eye:

But analysts cautioned about reading too much into economic indicators for January alone, given the strong seasonal distortions caused by the timing of the Lunar New Year holidays, which began on Jan. 31 last year but start on Feb. 19 this year.
…
Earlier data showed FDI in China rose just 1.7 percent in 2014, the slackest pace since 2012. The weak performance underscored a cooling economy which is spurring more Chinese firms to plow money into assets overseas in a trend that is soon set to overtake inbound investment.

In reaction to poor economic news and large capital outflows, the PBoC lowered banks’ reserve requirement ratios (RRR) by 50 basis points on February 4th and has framed recent poor numbers in the context of development growing pains. The government assures that China will experience a soft landing during the economy's transition from export and investment-driven growth to internal consumer-driven growth. Now the question remains as to whether China will effectively encourage private consumption and service sector expansion before their old growth model runs out of steam. Though the World Bank has only posted GDP data through 2013, we don’t quite see this transition of household consumption replacing investment and exports quite yet:

Source: World Bank

On the production side, we should expect a shift from low-end manufacturing to services. There is evidence that services is growing faster than manufacturing:

Source: National Bureau of Statistics of China

Yet services have quite a way to go:

Source: National Bureau of Statistics of China

China must rely on careful monetary and fiscal policy to prevent the gap between growth models from causing a hard landing. David Dollar at the IMF did a great job over the summer outlining China’s long-term reform agenda including infrastructure investment, financial liberalization, and opening up China’s service sector to competition. Now, we must see whether China advances with these reforms or falls back to debt-driven investment in manufacturing and real estate.

Sunday, February 15, 2015

The Greece-Eurozone dispute has received a great deal of attention in the media in recent weeks. It seems however that contradicting statements and polarized views - many tainted by various political agendas - have created a great deal of confusion around the subject. As the parties resume negotiations this coming week, lets look at what each has to lose if a solution is not reached in time.

The damage to the euro area

First of all it's important to point out that the so-called "Grexit" is equivalent to a complete failure to pay on obligations by the Greek government, its banks, corporations, and households. While everyone is focused on the €315 billion Greece owes to the Eurozone, the IMF, and others, the damage to the euro area would actually be much greater.

Source: Bloomberg

What nobody wants to talk about is the fact that internally most Greek loans - including mortgages - are in euros (some are even in Swiss francs). Greek banks hold €227 billion of loans and €12.4 billion of Greek government debt (plus roughly another €25 - €50 billion of Greek-based private sector bonds). Under a Grexit scenario, most debt (including government debt) will be converted to the new drachma at a preset exchange rate.

As the drachma collapses - and there is little question that it will - Greek banks, who would now have drachma assets and euro liabilities, will quickly fail as well, leaving the Bank of Greece holding the bag. The Bank of Greece which is currently part of the Eurosystem will therefore default upon exit. But before it exits, the Bank of Greece will draw on Target2 from the rest of the Eurosystem as Greeks quickly move their deposits out (see how the mechanism works here with the Bank of Spain example). And there is no question Greeks will try to move a great deal of their deposits out before they are converted to drachmas. In December alone they pulled €4.6 billion euros out of Greek banks - and that's before the Syriza victory.

The default by the Bank of Greece could cause even more damage to the system than the losses to EFSF and to other entities such as the IMF. Between the government bonds the Eurosystem holds and the Target2 losses, the ECB may need to be recapitalized - a political disaster. Market anxiety alone could push the euro area back into recession as credit conditions tighten again (potentially similar to the Lehman situation).

In the long run, if Grexit becomes a reality, the whole EMU could become unstable. History certainly isn't on the euro area's side.

Source: @RBS_Economics

Of course the Greek membership in NATO and the nation's ports on the eastern Mediterranean that are strategically important to the West could be in jeopardy as well. In particular, Greece's recent interest in establishing a stronger relationship with Russia (see story) is scaring a number of NATO generals.

The damage to Greece

Greece is quickly running out of time. And it's not just the debt maturity wall in 2015.

Source: @Eurofaultlines

We are talking about hitting the wall at the end of this month. Greek citizens are in the street these days with a new slogan "Bankrupt but Free". Of course it's all fun and games until pensioners line up at the soup kitchens and move into the homeless shelters because they can't get their retirement checks. It's a matter of weeks before Greek government employees no longer get their payments. Why is the situation so dire all of a sudden? Part of the problem is that the tax revenue is falling sharply now.

WSJ: - Government income has declined sharply in recent weeks as many Greeks have stopped paying taxes in hope that the country’s new, leftist government would cut taxes. Tax revenue dropped 7%, or about €1.5 billion euros, in December from the previous month and likely fell by a similar percentage in January, according to Economy Minister George Stathakis.

“We will have liquidity problems in March if taxes don’t improve,” Mr. Stathakis said.

Other officials warned the country would have difficulty paying pensions and other obligations beyond February.

And if the new government thinks their tax collection abilities will improve after Grexit, they are kidding themselves.

Furthermore, in the face of such uncertainty, Greek businesses will demand bags of drachmas for any goods and services they offer. And there is little chance that foreigners will accept drachmas for shipments of food, fuel, etc. With Greek government euro accounts frozen abroad after the default, access to hard currency will be cut off as the Bank of Greece will be forced to sell off its gold holdings. It's a humanitarian crisis in the making.

The compromise

Given such enormous risks to both parties a compromise will probably be reached. A bridge loan of some kind is likely in the nearterm. Beyond that we have some great unknowns and multiple rounds of "game of chicken" between the two parties.

One can sit around and pass the blame (see post) for the situation in which these parties find themselves today. But these are the harsh realities we are faced with and a longer term solution that softens the fiscal constraints on Greece while changing its liability structure will need to take shape. Otherwise the story of the European Monetary Union will enter its darkest chapter yet.

Sunday, February 8, 2015

China's trade report this weekend was dismal. Exports dropped 3.3% vs. economists' consensus of a 6.3% increase from last year. That is a 10% miss, demonstrating that the global community of professional China watchers do not have a clue about the nation's trade dynamics. This is quite unsettling given the importance of China to global growth.

A great deal of this weakness in exports was due to softer demand from the Eurozone and especially from Asia.

Reuters: - ... the data showed that while exports to the United States rose by 4.8 percent year-on-year to $35 billion, exports to the European Union slid 4.6 percent to $33 billion in the same period.

Exports to Hong Kong, South Korea and Japan were also down, with exports to Japan slumping over 20 percent.

But the real shocker came from the nation's import figures. Imports dropped by 20% from last year as the nation bought less (or paid less for) coal, oil and other commodities. Economists missed this measure by a whopping 17%!

As a result of the huge decrease in imports, China's monthly trade surplus spiked to a record of $60bn.

China's industrial demand has clearly suffered a decline in recent months - which explains the reason the PBoC chose to cut reserve requirements for banks (RRR - see chart/quote). However it is far from certain that this action will end up having the desired effect.

Fitch: - ... uncertainty remains as to whether the recent easing measures by the PBOC (including the earlier rate cuts in November 2014) will actually result in increasing credit to targeted sectors, such as small and micro enterprises. If banks utilise the monetary loosening to continue expanding credit in sectors which are already highly leveraged, it would exacerbate vulnerabilities in the system and be credit negative.

The question remains however if China watchers, both domestic and international, can develop a better insight into the nation's economic trajectory or if the projected figures continue to wildly deviate from reality.
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Diplomatic efforts are once again under way to establish a more lasting ceasefire in eastern Ukraine via the "Minsk peace talks redux" (see story). While Angela Merkel's diplomatic efforts should be applauded, chances for success remain poor. The Russian government simply has no incentives to stabilize the situation. Applying pressure on Western-backed Ukraine is part of Russia's foreign policy with significant popular support. Putin is not as interested in the Russian insurgents in Ukraine gaining autonomy as he is in embarrassing the West.

The military threat and the resulting humanitarian crisis in the east however are only a part of the threats Ukraine is now facing. The nation's economy is in deep trouble and the fiscal situation is becoming increasingly untenable.

The nation is running out of foreign exchange reserves after defending the currency in the face of significant capital flight over the past couple of years. Exports have collapsed, with Russia being the key export market.

Desperate to stabilize the currency without wasting much more of the dwindling reserves, the central bank hiked interest rates to 19.5% last week. Domestic credit markets are now shut.

To relieve the pressure from capital outflows, the Ukrainian currency (hryvnia) was allowed to plummet some 36% against the euro last week - an unprecedented move. There is very little the central bank can do now.

Chart shows EUR appreciating against UAH

Such currency weakness will sharply exacerbate Ukraine's inflation, which is already running close to 30%.

And growth is now deep in negative territory. The GDP, the industrial production, and retail trade are all experiencing a double-digit contraction.

Source: Barclays Research

Default or debt restructuring in 2015 is now inevitable. Some of the recent proposals have focused on simply extending the nation's bond maturities. Foreign currency denominated bonds (Ukraine's eurobonds) are of particular concern (chart below). But Ukraine has other FX denominated debt outstanding - including USD-based bonds issued domestically as well as debt to the IMF.

Most of the dollar-denominated bonds already trade around 50 cents on the dollar.

Source: Barclays Research

Whether maturity extensions or a principal haircut, unless Ukraine sees fresh bailout funds soon, a credit event is now just a matter of months - possibly weeks. The current economic and fiscal trends are unsustainable and the near-term dollar-denominated debt maturities are simply untenable.
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